TIPS Are Grossly Overpriced

Treasury inflation protected securities, better known as TIPS, are bonds issued by the U.S. Treasury Department and are backed by the full faith and credit of the U.S. federal government. Or to be somewhat more blunt, TIPS are backed by the unqualified ability of the U.S. Treasury (potentially in conjunction with the U.S. Federal Reserve) to print whatever amount of money might be required to pay them off at maturity or to make their semi-annual interest payments. TIPS are interesting because they are protected from the ravages of inflation. Here is how they work. The coupon rate is fixed and unvarying. However, the maturity value is adjusted for changes in the CPI (consumer price index). Moreover, because the semi-annual interest payments are based on that maturity value (even though the coupon rate remains fixed), the dollar size of the interest payments also adjusts for the CPI. Thus a TIPS holder is protected from future changes in the level of consumer prices. There remain a few other nuances concerning the provisions of these bonds, but they are incidental to this discussion.

Basis For Popularity
TIPS are unusually popular today with both retail and institutional investors. This enthusiastic popularity is being driven by a fear of inflation. The source of this fear grew out of the actions of the U.S. Federal Reserve, executed over the last five years. When examined in a historical context, the Federal Reserve has implemented policies (since January 1998) that were revolutionary in their scope; these actions made history and have taken us deeply into uncharted waters. Not unreasonably, investors have responded with fear and uncertainty. Let’s recap the Fed’s actions:

• Total U.S. Federal Reserve bank credit grew from $900 billion in September 2008 to $2,900 billion in December 2012.

• Securities held outright by the Fed grew from $500 billion in February 2009 to $2,700 billion in December 2012.

• Mortgage Backed Securities (mortgage bonds) bought and held by the Fed grew from zero back in January 2009 to $900 billion in December 2012.

• The U.S. money supply has grown at unprecedented levels (i.e., the Fed has been “printing money”):

• The global money supply growth peaked at 22 percent on a year-over-year basis back in mid 2008.

Recognize that these data are truly exceptional and as stated above, take us deep into unknown waters. In normal times, one would rightly expect such “running of the printing presses” to result in a truly fearful resurgence of inflation. But most investors are not adequately appreciating that these are not normal times -- far from it. We continue to experience both national- and global-deleveraging. And no single force better and more completely mitigates the return of inflation than deleveraging. Let’s examine the data in greater detail.

Inflation Won’t Be Coming Back
Inflation won’t be coming back to the U.S. -- at least not for the foreseeable future. Based on the data available today, inflation will remain fully dormant for the next 24 months. But of course, new and different data will arrive tomorrow, and at that point, an understanding and appreciation for the next 24 months could change. Nevertheless, based on today’s facts, inflation remains a nonexistent threat for the next two years. Here are the economic data as of today:

• Deleveraging continues apace and is expected to continue for many more years to come -- both nationally and internationally:

° Total domestic financial debt as a percentage of GDP has fallen 6.66 percent year-over-year through 9/30/12 and
° Total credit market debt of all types and for all sectors as a percentage of GDP has fallen 1.92 percent year-over-year through 9/30/12.

• Import prices (the prices of all the goods and services that we import into the U.S.) have fallen 1.6 percent year-over-year through 11/30/12.
• Nonfarm unit labor costs have risen only 0.1 percent year-over-year through 10/31/2012.
• The productive capacity of the U.S. economy remains heavily unused or underutilized, thus preventing price increases:

° The national capacity utilization rate is running at only 78.4 percent of total capacity as of 11/30/12 and
° Real industrial capacity (how much we could produce if we turned on all the factories) increased by 1.5 percent year-over-year through 11/30/12.

• The inflation pipeline already has falling prices baked into the manufacturing and distribution processes, i.e.:

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Expert Views

A person who believes a huge financial gamble is about to pay off experiences the same brain activity as in one about to get a hit of cocaine, and the thought of a financial windfall is even more powerful than the sight of a naked body, he writes.